10 Tax Breaks for Investors
Remember, it’s not just how much you make but how much you keep. With these investments and strategies, you get to keep more.
The U.S. tax code holds many breaks for investors. You'll likely be familiar with some of them, such as tax-free income on municipal bonds. Others are far more obscure. Yet, during tax season, it's helpful to review all the breaks you can take — even if you missed them in 2012. They may help trim your tax bill in the future.
Some of the tastiest tax treats were originally designed for a rarefied clientele: venture capitalists and multimillionaire "angel" investors, who make a living finding and financing small companies. But new rules allowing corporate "crowd funding" arrangements may make these tax rules far more pertinent to average investors, who might become tempted to help finance a friend's or neighbor's new enterprise.
Here's a guide to ten sweet tax treats for investors — some ordinary, some extraordinary.
Preferential rates: Marginal income tax rates rose to a maximum of 39.6% in 2013, from 35% last year. But profits on the sale of stocks and bonds held for more than a year are taxed at preferential rates that cap at 23.8% for those in the highest income brackets and drop to 15% for middle-income filers and to zero for those in the 10% and 15% marginal tax brackets.
Most dividend income is also taxed at these lower rates. But beware selling investments before you've owned them longer than a year. Short-term gains get hit with higher ordinary income tax rates. And some types of dividend income, such as the income thrown off by real estate investment trusts, are taxed at those higher rates, too.
Capital-gains exclusion: If you buy stock in a "qualified small business" and hold that stock for at least five years before selling, you don't have to pay tax on the gain at all. The profit is excluded from your income. What's a "qualified small business"? The definition is long, but the main qualification is that it must have less than $50 million in assets both before and after issuing stock. Additionally, you must have purchased the stock at original issue or received it as payment for services provided to the company. Incidentally, this tax break officially expired at the end of 2011, but Congress reinstated it recently in the legislation to avoid the "fiscal cliff." Now the break covers stock purchased in 2012 or 2013. As long as you buy before the expiration, you qualify for the exclusion if you hold on for at least five years, says Mark Luscombe, principal tax analyst with CCH Inc., a Riverwoods, Ill.–based publisher of tax information.
Capital-gains rollover: Don't want to hold that qualified small-business stock for five years, but you're interested in buying shares in another qualified small business? Then there's another tax provision designed just for you. Assuming that you held the first stock for at least six months, you can defer the tax on your gain by rolling the proceeds from the sale into the purchase of another qualified small business. Philip J. Holthouse, partner in the Los Angeles tax firm of Holthouse, Carlin & Van Trigt, says this law was specifically designed to help angel investors, affluent investors who provide capital to start-ups, sometimes making a fortune and other times losing a fortune. The law allows these angels to keep more of their profits for reinvestment, and net their gains and losses over a longer stretch.
Valuable losses: If you invest in a really small company — one with less than $1 million in assets — and lose your shirt, you may be able to write off the loss as an ordinary loss rather than a capital loss, says Holthouse. Based on "1244" rules, up to $50,000 in losses on a qualified small domestic corporation can be used to reduce your ordinary income, which otherwise would be taxed at a maximum rate as high as 39.6%.
Tax-free income: If you invest in municipal bonds issued by an entity in your state, the income earned on those bonds is likely to be "double tax-free" — exempt from both federal and state income taxes. If you buy out-of-state munis, the interest is usually free from federal tax. However, there are a few caveats. The most noteworthy is that tax-free muni-bond income is added into the calculations that determine how much of your Social Security benefits are taxable. For middle-income seniors, that can push thousands of otherwise untaxed income into the taxable column, making municipal income a little less tax-free than it might appear.
New-markets tax credit: The new-markets tax credit is an incentive to invest in so-called "community development" corporations. These are for-profit companies that do a wide array of community work, much of it involved with helping low-income individuals save for major goals or items, such as paying for college, starting a business or funding retirement. While these entities are designed to be profitable, the profits are not likely to rival less-philanthropic enterprises, so the U.S. Department of the Treasury spikes the return by providing tax credits. Each year, investors in qualifying community- development companies get tax credits amounting to 5% to 6% of their investment. Over the course of seven years, that returns about 39% of investors' capital in the form of dollar-for-dollar reductions in the amount of tax they owe.
Low-income housing credits: The government also provides generous tax credits to those who invest in low-income housing. The credits vary based on the type of housing and whether it was built new or rehabilitated, but the projects are often designed to give investors tax breaks that exceed their total investment in the real estate, says Holthouse. Typically, the developer of a project will secure the tax credits and sell interests in the deal to investors through limited partnerships.
Passive-activity losses: If you invest in rental real estate, you also may be able to write off as much as $25,000 per year when the depreciation and other costs of owning and renting the property exceed the income earned from it. The $25,000 write-off begins to phase out for those earning more than $100,000 and is eliminated completely when earnings exceed $150,000.
Company stock in a 401(k): If you own the stock of your employer in a 401(k) or in an employee stock- ownership plan, there's a special provision that allows you to transfer your employer's stock from the plan into a taxable account without paying tax on the current value of the stock. Instead, you pay tax on your "basis" — what you paid — for the shares. Tax on any appreciation in the stock would be deferred until you actually sold the shares, and then the tax would be calculated at capital-gains rates, rather than ordinary income tax rates that usually apply to distributions from retirement plans.
To illustrate the tax savings, consider an employee who bought $100,000 in shares in his employer's company over a 30-year career. At the end of that career, these shares were worth $500,000. When he retires, he can transfer those employer shares into a brokerage account and pay tax only on the $100,000. When he eventually sells the shares he'll have to pay tax on the deferred $400,000 gain (assuming the stock maintains its value) but at capital- gains rates, not ordinary income tax rates. Assuming he's in the 28% bracket, that saves him a fortune — the difference between sharing 28% of the deferred gain with Uncle Sam and paying taxes at the 15% capital-gains rate. In this case, that would be a $52,000 benefit.
Donating appreciated stock: Now if this stockholder got really generous, he might not need to pay tax on that gain at all. He could donate the stock and take a write-off for its current market value. Naturally, he'd be out the stock, which means he gave up something of real value. But it also would eliminate the need to pay capital gains on the profit — and he'd get a write-off, too.